Trading Secrets Revealed 2.0©| David · PDF fileof the golden rules of trading. We all know that. But ... it’s also going to tell them the exact point at the top of the trend when

TradingSecretsRevealed2.0©|DavidJenyns1


TableOfContentsAcknowledgments.............................................................................................................................. 3Chapter2:.............................................................................................................................................10Fixedcosts ......................................................................................................................................11Floatsizeandtradingstyle......................................................................................................11Sourcingthemoneytotrade ..................................................................................................12

Chapter3:.............................................................................................................................................13Definingyourmaximumloss..................................................................................................13Calculatingyourpercentagerisk ..........................................................................................15Calculatingyourtradingfloatforleveragedinstruments .........................................16

Chapter4:.............................................................................................................................................17Settinganinitialstop .................................................................................................................17Initialstopmethods....................................................................................................................191.Percentagemethod ................................................................................................................192.Averagetruerange(ATR)method..................................................................................20

Chapter5:.............................................................................................................................................24Theformula....................................................................................................................................24

Chapter6:.............................................................................................................................................27Theroleoftrailingstops ..........................................................................................................28Methodsofcalculation ..............................................................................................................30

Chapter7:.............................................................................................................................................33Fullyworkedexample ...............................................................................................................33Day1:EntryTriggered..............................................................................................................34Day2:Alterationoftrailingstoploss .................................................................................35Day3:Makingtheinitialstopobsolete..............................................................................36Day5:Leavingstoplossunaltered(1)...............................................................................37Day22:Leavingstoplossunaltered(2) ...........................................................................38Day23:Increasingtrailingstoploss ...................................................................................39Day63:Gettingstoppedout ...................................................................................................40Finaltradesummary..................................................................................................................40Theworsttradingstrategy......................................................................................................41Averagingup:thesmarterwaytogo..................................................................................42

Chapter9:.............................................................................................................................................43Compounding:Theeighthwonderoftheworld............................................................43Twotypesofmistakes ...............................................................................................................44Tradingwithoutacoach...........................................................................................................46


Acknowledgments

Iwishtothankallofyou–thereadersofthispowerfulmoneymanagementmanual.Mypurposeinwritingitwastomaketheseprovenstrategiesforsuccessavailabletoyou,theprivatetrader,whetheryou’reabeginnerortradingveteran.

Iwouldalsoliketoacknowledgeandthankthefollowingpeoplefortheparttheyhaveplayedinmytradingevolution.Myownpassionforthisexcitingandchallengingworldhasbeenfurtherfuelledbytheinspiringseminarpresentations,publishedmaterialsandworksofDrVanTharp,JohnPiper,JackDSchwager,EdwinLeFevre,NicolasDarvas,StanWeinstein,StuartMcPheeandtheteamatHomeTrader.


IntroductionAchievingfinancialsuccessinthemarketsisnoteasy.Ittakesdiscipline,determinationandawell‐tested(andwell‐followed)plan.Despitewhatsomemightsay,theskillsrequiredtobecomeasuccessfultraderarenotinbred.Anyonecanlearn.And,astradingguruDrVanTharppointsout,it’smoreaboutmindsetandpsychologythatanythingelse.Thereasonpsychologyissuchanimportantpartofbecomingasuccessfultraderisthatalotofwhatyouhavetoovercomeiscounterintuitive.Cutyourlossesandletyourprofitsrun.It’soneofthegoldenrulesoftrading.Weallknowthat.Butstickingtothatrulewhenyou’reinthetrenchesisthehardpart;itgoesagainstwhatmanyofusseeasthe‘natural’thingtodo.Ourinclinationistoletourlossesruninthehopetheywillturnaroundandtocutourprofitsshortinfearoflosingthem.

But,towinintrading,youhavetolearntogoagainstthegrain.That’swherethisbookcomesin.

Thefactis,thereareliterallyhundredsofperfectlygoodentriesandtherearejustasmanywaystomakemoneyinthemarkets;butthat’snotwhatmakesagoodsystem.Atthecoreofanysuccessfultradingsystemisthesamecriticalcomponent:excellentmoneymanagement.Youneedtohaveamethodinplacetoprotectyourcapital.Nosystemisgoingtotradewith100percentaccuracy.Allittakesisonebadtradetoloseitallandthat’swhymoneymanagementissoimportant.

InmybookUltimateTradingSystemsIintroducedyoutothebasicskillsofbecomingasuccessfultrader.Italkedabouttheimportanceofdefiningwhyyouwanttobeatrader,thedifferencesbetween‘good’and‘bad’traders,andhowtodesignawinningtradingplan.Italkedbrieflyaboutentries,exitsandmoneymanagementandIintroducedyoutochartingsoftware,thebasicsofchoosingabrokerandtheartofbacktesting.InUltimateTradingSystemsIsaid,nexttoyourpsychology,thatthemostimportantaspectoftradingismoneymanagement.Thatsaid,todate,Ihaven’tyetfoundacoursethatexplainsthiscriticalaspectoftradingasIbelieveitshouldbeexplained.That’swhyIwrotethisbook.

Idon’tclaimtobetheonlyonetorecognisethatmoneymanagementistheHolyGrailwhenitcomestotrading.Infact,manyothersuccessfultraderscitemoneymanagementasacoreprincipleoftheirsuccessinthemarkets.Forthisreason,I’mnotgoingtoattempttoreinventthewheelhere.Mygoalforthisbookistobringthebestofthebestinmoneymanagementalltogetherinoneconcisepackagethatcanthenbeappliedtoanytradingsystem.Nomatterthemarket,timeframeormethod(longorshort).Thefactis,themoneymanagementrulesIsetoutneedtobeappliedtoallsystemsregardlessofwhatyou’retrading.Noexceptions.


Administrationnote:fortheeaseofcontinuityIwilltalkmostlyintermsof‘stocks’,butpleasebeawaretheconceptsapplytoallmarkets.Moreover,someoftheseconceptsmaynotbenewtoyou;however,Iwouldliketoputforwardtheideathatifyou’renotcurrentlysuccessfultradingthemarket,oryou’renotachievingthesuccessthatyouwouldliketoachieve,theproblemwillmostlikelybepoordisciplinewithmoneymanagement.It’sonethingtoknowtheserules;it’sanothertoactuallyapplythem.Everyoneisatadifferentpointintheirtradingjourney.So,forsomepeoplewhoreadthisbook,itwillbeanewideaaminute.Forotherswhoarefamiliarwithmoneymanagement,youmaypickuponlyafewfinerdistinctions.Pleaserememberthatallittakesisonenewidea,onefinerdistinction,andyoucanwatchyourtradingprofitssoar.I’vetriedtoavoidusingconfusingfinancialstockmarketjargon.Someofthesetermsarenotwellunderstoodbythepublicandmaketheworldofstockinvestingseemlikesomesortofalchemy.Theemphasishereisonkeepingitsimple.Thiswillnotbethemostcomplicatedorscholarlybookthatyouhaveeverinvestedin,butitmaybeoneofthemostsimpleandmostpractical.Whycomplicatethingsunnecessarily?InthisbookIwillcover:definingyourtradingfloat;settinginitialstops;positionsizing;calculatingtrailingstops;andthebestandworsttradingstrategies.Iwillalsogiveyouafullyworkedexampleusingallthematerialyou’velearned.I’vealsoprovidedaQ&Asectionasanappendixtohelpyoureviewthemajorlearningpoints.Iwantyoutounderstandwhatyou’redoingandwhyyou’redoingit.Onceyouhaveagoodsysteminplace,youwon’tneedtofollowmarketgurus,full‐servicebrokers,tipsheetsoranythinglikethat.

Iwantyoutohavetheconfidenceofknowingthatonceyouenterintoatradeyou’llalreadyhaveyourexitstrategypredefined,enablingeventhebusiestpersontomanageanaggressiveportfolioofsecuritieswithonlyfiveminutesaday.Mostimportantly,you’llbeabletosleepatnightbecauseyourriskswillbetailoredtofityourlevelofrisktoleranceandconfidencelevel.Letmeassureyouallthesegoalsandmorecanbeachievedbysettingexcellentmoneymanagement.

Finally,beforewegetintothegutsofthebook,Iwantyoutonotethatthisbookissetoutinaparticularorderforareason.Ithasbeendesignedasmoreorlessastep‐by‐stepguidetomoneymanagementthatwillworkbestifappliedinthisorder.Lookingbackmighthelpyouattimes,skippingaheadwon’t.

Now,gotoit!

DavidJenyns|ProfessionalTrader,Author&Coach


Chapter1:It’snotintheentryIt’sfunny.Despitetheprovenimportanceofmoneymanagement,manyofmyclients,whentheyfirstcometome,stillfocustheirtimeandenergyonlookingfortheperfectentry.It’sthatsearchfortheHolyGrail.Theywantaperfectindicator.Theybelieveit’sgoingtobetheperfectindicatorthatslaysthemarket.Notonlyisthisindicatorgoingtogettheminrightatthebottomofthetrend,butit’salsogoingtotellthemtheexactpointatthetopofthetrendwhentogetout.Unfortunately,eventhoughIdon’tliketodisappointmyclients,Ineedtoletthemknowonethingupfrontwhentheycometome:thereisnoperfectindicator.

Sowhydopeoplebelievethereis?TradingguruandauthorVanTharpsuggestsit’sduetothefactthatmanynovicetradersfeelthatbybeingintrinsicallyinvolvedintheselectionandentryintoaparticulartradetheysubconsciouslybelievetheyaresomehowincontrolofthemarket.Hecallsthisthelottobiasanditcanalsobewitnessedinpeoplewhopicknumbersthataresignificanttothem–forexample,datesofbirthdaysorotheranniversaries–whenplayingthenationallottery.Pickingthesenumbersgivesthepunterasenseofcontrolandpower.Theyfeelthatsomehowthesenumbersarebetterthananyotherandaremorelikelytowin.Inreality,thenumberschosenarenomoresignificantthananyothercombinationavailable.Itisthefactthattheyhavelinkedanimportantemotionalattachmenttocertainnumbersthatgivestheplayerasenseofcontrol–ithasnothingtodowithincreasingthelikelihoodofwinning.Tradersdothesamewiththeirentry.Whenenteringintoatradingpositionyouareinabsolutecontroloftheentry.Youdecidewhetherornottopullthetrigger.Unfortunatelymosttradersholdontothissenseofcontrol;however,onceyouareinatradeyouhaveabsolutelynocontroloverthedirectionthemarkettakes–itwilldowhatitwants!Thefundamentaltruthis:it’snotwhenyoubuythestockthatdetermineshowmuchmoneyyoumake,it’swhenyouexitandmostimportantlyhowmuchyouputintothetrade.


Thefollowingexamplemayclarifythispoint.Example

YouareinterestedinbuyingstockXYZ.Yourtradingsystemtellsyoutobuythestockat$10.Yourexitsignalisgeneratedwhenthestockhits$12.Letusconsidertwoscenarioswhereyouinvested(1)$1,000and(2)$5,000.

(1)For$1,000youwillbeabletopurchase100sharesat$10.Youwillsellthesesharesfor$1,200whentheyhit$12.Thisresultsinaprofitof$200ontheinitialinvestment.

(2)For$5,000youwillbeabletopurchase500sharesat$10.Youwillsellthesesharesfor$6,000whentheyhit$12.Thisresultsinaprofitof$1,000ontheinitialinvestment.

Itsoundselementarybutitisnottheentrythatdetermineshowmuchyouwillwinorlose,itisactuallytheamountofmoneythatyouputonthetradeinthefirstplace.Thisisacoreprincipalinsettingexcellentmoneymanagement.Youcanbewrongmorethanyou’rerightandstillmakemoney!

Thetruthisyou’regoingtohaveasystemthatsometimeswinsandsometimesloses.So,evenifyouhavetheworld’smostaccuratemethod,overtimeyouwillgobrokeifyoudon’trecognisetheindividualityofeverytradeandpracticegoodmoneymanagement.ThegoodnewsisIknowofmanysuccessfulspeculatorswhohavesuccessratesof30–50%andthey’restillhugelysuccessful.They’renotsuccessfulbecausetheypredictpriceswell,they’resuccessfulbecausetheirprofitabletradesfarexceedtheirlosses.Thestoryofthe‘TurtleTraders’isagoodexamplehere.RichardDennis,awell‐knownsystemstrader,decidedtotesthistheorythatsuccessfultradersaremade,notborn.Todoit,hetrainedupagroupofstudentsandoversawtheirprogressastheytradedhisownsystemtotheletter.

ThesystemDennisimpartedtohisprotégéslost60%ofthetimeandwononly40%,buttheystillmademoney.Infact,thissystemoverallwasincrediblysuccessful.Why?Becausethelossesweresmallandthewinswerebig.

Let’slookatthisideainamoreconcreteexample.

Letusassumethatyourtradingsystemprovidesaprofitabletradeonlyathirdofthetime.Thatistosayforeverythreetrades,oneisprofitableandtwoarenot.

Let’ssaythatforeveryprofitabletradeitisfourtimesmoreprofitablethantheequivalentlossinthelosingtrade.Inotherwords,ifawinningtradegeneratesaprofitof$400,theequivalentlosingtradewillmakealossof$100.

Letusnowtakesixrandomtrades(seetable1.1).Accordingtoyoursystem,twooftheseshouldbeprofitableandfouroftheseshouldnot.


Study and research into the state-of-the-art in money management will pay enormous dividends.

RichardDennis

Table1.1:Winningwhileyou’relosing

Astable1.1shows,eventhoughthesystemwins,onaverage,onlyone‐thirdofthetime,thefinalresultisstillaprofitableone.

Thereasonforthisissimple:eachwinningtrademorethancompensatesforthelosingtrades.ThepointI’mtryingtomakehereisthatyoudon’tneedtofindthepinnacleofallindicatorssinceit’snotaboutgettingtheentry‘justright’.It’scertainlypartofitbutthere’salotmoreimportantthingstoworryabout...likemoneymanagement.

Whatismoneymanagement?Intrading,thekeytosuccessissimplytomanageyourrisk.Inshort,moneymanagementissimplyasetofrulesandguidelinesthatkeepyourriskatalevelatwhichyou’recomfortable.Ifyouplaytooriskyinthemarket,youwillcertainlyloseinthelongrun.

Yourmoneymanagementruleswillpreventyoufrommakingthismistake.Akeyunderstandingtorememberintradingisthateachtradeisindependentoftheprevioustrade.Ithasnobearingonwhetheryouwillwinorloseinthenexttrade.

I’moftenremindedofthiswhenIthinkbacktoastrategyIdevelopedforgamblingatthecasinos.IthoughtI’dcomeupwiththeultimatesystemforplayingroulette.Mysystemwas:lookforastringoftheonecolour,soeitherfiveredorfiveblack,andthenbetontheopposite

Tradenumber

Winnerorloser

Profit/loss($)onthesingletrade

1 Loser ‐100

2 Loser ‐100

3 Winner +400

4 Loser ‐100

5 Winner +400

6 Loser ‐100

Totalprofit +400


colour.IfIdidn’twinthatoneI’ddoubleupandthenkeepdoublingupuntilIcameoutontop.Needlesstosay,Iendeduplosingallmymoney.

That’showIlearnedthekeyruleofmoneymanagement.Itdoesn’tmatteriftherearefiveredsorfiveblacksinarow,ithasnoeffectonwhatisgoingtohappennext.Tradingisexactlythesame–itisinevitablethatacertainnumberoftradeswillgoagainstyou.Thetradeyouplacedandwonpreviouslyhasnobearingonthenexttradeyouplace.Knowingnosystemgetsitright100%ofthetimeandthateachtradeisindependentoftheprevious,excellentmoneymanagementrulesensureourpositionsaresmallenoughthatwedon’tblowourcapital,yetlargeenoughtomaximiseprofit.


Chapter2:

TradingfloatThefirststepyouwilltakeinsettingyourmoneymanagementrulesistodefineyourtradingfloat,inotherwords,theamountofcapitalthatyouhavetotradewith.Infact,oneofthemostcommonlyaskedquestionsIgetis,‘HowmuchdoIneed to actually start?’

To help you answer that question you need to first define your objectives. I listed these in Ultimate Trading Systems as:

• How much time do you have to spend trading? That might be full time, part time or hardly any time.

• How much capital do you have to work with? Remember, you shouldn’t trade money you’re not comfortable losing.

• How much risk are you comfortable with? As we all know, markets move. There’ll be times when you have a drawdown. The question then becomes: how much of a drawdown are you comfortable with? 20%? 30%? You need to decide.

• What annual rate of return do you want? This includes what you expect to make and in what time frame. Be realistic about this. Decide what you honestly think will be returned based on what you’re willing to risk. For example, you’re not going to have a system that will return 100% per year if you’re only prepared to risk a drawdown of 5%.

• How do you want to take your money from the market? Are you looking for cash flow (consistently taking profits out of the market) or capital growth (looking to grow your capital in the market over time, using the magic of compounding)?

Allthesedecisionsneedtobebasedonyourincomeobjectives.Areyouinittomakeasteadyincomeorareyoulookingatlong‐termgrowth?Andremember,thereisnosetpaychequeintrading.It’snotareliableincome.Youwillhavegoodmonths,evengreatmonths,butthenalull.Sodon’tquityourdayjobjustyet!

Toptip

Iwanttomake200%ayear–thatisn’tunreasonableisit?

Manyexpertinvestmentfundmanagersbarelymakemorethan20–30%ayear(andmanyevenmakealoss).Youhavetheadvantageofmovingquickerbutstillavoidoverestimatingyourreturnpotential.Generallyspeaking,youshouldavoidfocusingonyourROItoomuchinthefirstonetotwoyears.Usethistimetofinaliseyourplananddevelopgoodtradinghabits–theprofitswillthenfollow.


Fixedcosts

Althoughthereisnoperfectamountofcapitaltostarttradingwith,it’snosecretthatthebiggerthetradingfloatyoudobeginwith,theeasieritistotrade.Thatis,ofcourse,becauseofthefixedcostsassociatedwithtrading.

Themajoronetobeawareofisbrokerage.Dependingonwhichbrokeryougofor,manybrokerschargeaflatfeeandit’sthetraderswiththelargerfundsizewhohaveitalittlebiteasier.Forexample:twotradersarelookingatopeningatrade;thefirsttrader’spositionisvaluedat$1,000andthesecond’sisat$10,000.Assumebothtradershaveidenticalbrokeragecostsat$100pertrade.Thetraderwiththelargeraccountsizehastheadvantagebecauseourfirsttrader(who’strading$1,000)wouldhavetomakeback10%beforeshewouldevenreachbreakeven.Tradertwo,however,onlyneedstoincreasehercapitalby1%beforeshereachesbreakeven.There’snothingstoppingyoustartingouttradingwithasmallertradingfloat;however,thosewhodostartwithasmallertradingfloatareslightlydisadvantaged.

Floatsizeandtradingstyle

Yourtradingfloatsizeisgoingtodeterminewhattypeofsystemyou’regoingtotrade,too.

Ifyou’relookingattradingveryshorttermsystemssuchasday‐tradingsystems,they’rebestsuitedtolargertradingsizes.Irecommendthatwhenyoufirstbegintradingthatyoulookattradingalongertermtradingsystem.Therearemanyreasonsforthis,oneofthemostobviousbeingthatyoucaneasilymanageaverysuccessfullong‐termtradingsystemwhilestillworkingfulltime.Onceyou’vetastedalittlesuccess,youmightlookatshorteningyourtimeframeandfocusingmoretimeontradingitself.Also,withalongertermsystem,you’llbeincurringalotlessbrokerage.

Table2.1looksatthedifferingattributesofshortandlong‐termtradingsystems.


Table2.1:Attributesofshortandlong‐termtradingsystems

Shortterm Longerterm

Tradelength 1–30days 1month+

Numberoftrades Moretradestaken Lesstradestaken

Win–lossratio Highernumberofwins Lowernumberofwins

Tradingobjective Income Capitalgrowth

Timerequired Moretime Lesstime

Capitalrequired Morecapital Lesscapital

Experiencerequired Moreskill Lessskill

Sourcingthemoneytotrade

Maybeyou’vebeenplanningtotradeforawhileandyou’veamassedawadofmoney.That’sgoodplanning.Or,maybeyou’replanningonborrowingit.Maxingoutyourcreditcardsisprobablynotthebestwaytogetstartedinthetradingbusiness.Ifyou’reabitmoreexperienced,borrowingfromthebank(likeyouwouldwhenstartinganysmallbusiness)isfine.Butremember:themoremoneyyouhavetoinvest,themoreyourresultswillbemagnified.Ifyouwinbig,youwillwinreallybig.Ifyoulosebig,thesameapplies.It’sbesttogetalittleexperiencebehindyoubeforeyougoandstartspendingthevolumeofmoneyyouwouldon,say,aninvestmentproperty.

Worryingabouttradingprofitsishardenoughwithouthavingtoworryaboutdebtserviceonyourcreditcardaswell.Inthiscase,you’renotconcernedwithgoodtrading,you’refocusedonmakingpayments.DonMillertalksaboutthisinTradingMarketsWorldMeettheTraderswhenhetellsnewtraderstoworryabouttradingwell,notmakingmoney.

Quittingyourdaygigtodaytradeisabadideaunlessyou’vegotapileofmoneytokeepyouafloatwithnoworriesforatleasttwoyears.Afantasticwaytolearnistobegintradingonapart‐timebasis.Thatwayyou’vestillgotanincomestreamwhileyou’rehoningyourskills.Theadvantagehereisthatyou’renottradingyourrentmoney.

Insummary,howmuchcapitalyoustartwithwilldependonhowmuchmoneyyou’vegot,yourlevelofrisktolerance,theinstrumentsyou’relookingtotrade,andwhattimeframeofsystemyou’replanningtotrade.Thereisnoperfectamountofcapitaltobegintradingwith.Thekeyistosimplydefinehowmuchcapitalyou’retradingwithandhaveitsetupasaseparatebusiness.Thatwayyou’renotdrawingontheprofitsallthetimeandlosingyourfocus.

Remember,yourtradingisabusinessnow.Iwouldrecommendhavingaminimumof$10,000.00togetstarted.


Never risk more than 1% of your total equity in any one trade. By risking 1%, I am indifferent to any individual trade. Keeping your risk small and constant is absolutely critical.

LarryHite

Chapter3:

MaximumlossAfterdefiningyourtradingfloat,thenextthingyouneedtodoinsettingexcellentmoneymanagementistodefineyourmaximumloss.Themaximum

lossisquitesimplythemaximumamountofcapitalthatyou’rewillingtoloseonanyonetrade.Thereasonfordefiningthisupfront(beforeweevenopenatradingposition)istomakesurewecansticktooneofthecardinalrulesoftradingandthatistokeepourlossessmall.Wewanttomakesurewesetourmaximumlossasasmallpercentageofourtradingfloatsoitwon’thaveadetrimentaleffectifwehaveastringoflosses.Mosttradersfailinthemarketsbecausethey

risktoomuch.AsIsaid,thegoalistokeepourlossesassmallaspossiblewhilealsomakingsurethatweopenalargeenoughpositiontobeabletocapitaliseonprofitsaswell.FormerAustraliantestcricketcaptainSteveWaughsaysthebestadvicehewasevergivenonthecricketpitchwastosimplynotgoout.Whathemeantwasifyou’redismissed,youcannolongerscoreanyrunsandthereforenotwinthegame.Gettingruns,Waughsuggests,shouldnotbeyourprimaryobjective;youshouldfocusonstayinginthegame.It’sthesameintrading.Youneedtoprotectyourfloatjustasyouwouldprotectyourwicketincricket.Ifyou’rebowledout,youcannolongerplay.

Irealiseitmightseemlikeasomewhatnegativeordefeatistattitudetospendtimethinkingaboutthemaximumyoucanbeartolosebut,likeI’vesaidbefore,muchofthepsychologyofagoodtraderiscounterintuitive.It’saquestionofsurvival.Youwanttotakeadefensivestancewhenitcomestotrading.ToptraderEdSeykotadefinedthethreeelementsoftradingas:(1)cuttingyourlosses;(2)cuttingyourlosses;and(3)cuttingyourlosses.Ifyoufollowthoserules,hesaid,youmighthaveachance.

Thefirststepistoacknowledgethatlossesareapartoftrading–everyonehasthem.Youneedtoacceptitwhenithappensandmoveon.Gettingupsetaboutalossonlycloudsyourjudgement,whichcanbetradingsuicide.Aclearheadiseverything.

Definingyourmaximumloss

So,thequestionremains:whatshouldbeyourmaximumloss?Maximumlossisusuallyrepresentedasapercentageofyourtradingfloatandstudiessuggestyoushouldneverriskmorethan2%onanytrade–knownasthe‘2%rule’.However,


manyproswilltellyouthatthisiswaytoomuch.They’llriskanywherefrom1%toevenaslittleasaquarterofapercentonanyonetrade.Thecoreprincipalbeingthatnoonelossisreallygoingtoaffectyou.Thatsaid,typicallyspeaking,yourlossesmaybesmall,butsowillyourprofits.

Let’slookatanexampleofthe2%ruleinaction.Ifwehadatradingfloatof$20,000,applyingthe2%rulewouldmeanourmaximumlosswouldbe$400onanyonetrade.Thebeautyofhavingmadelossessosmallbyusingthe2%ruleisthatweneedahugestringoflossesbeforeourentiretradingfloatiseroded.Wewouldneedastringof50lossesinarowbeforewehadnomorecapitallefttotradewith.Inmosttradingsystemsthechancesofgetting50lossesinarowisvery,veryslim.However,thechancesofgoingbrokeareevensmallerthanthatbecausewhenyouimplementthe2%rulecorrectly,that2%isactuallycalculatedonthecurrentfloatsize,nottheinitialfloatsize.

Letmeexplain.

Wealreadyestablishedthat2%of$20,000is$400.However,ifweexperiencedalossfirstoff,ourtradingfloatwouldnowbereducedto$19,600.Ifwethencalculate2%ofthisnewtradingfloatvalue,weshouldthenusethisfigureasourmaximumlossforournextposition.Twopercentof$19,600wouldbe$392.So,youcanseethatwitheveryfallinequityourmaximumlossfallstoo.

Here’swhatwouldhappenifwesustainedsixlossesinarowbasedonthesenumbers.Float: $20,000

Afterloss1: $19,600

Afterloss2: $19,208

Afterloss3: $18,824

Afterloss4: $18,447

Afterloss5: $18,079

Afterloss6: $17,717

Ourtradingfloat,afterreceivingsixlossesinarow,wouldhavedecreasedtoonly$17,717.Thatmeanswe’veonlylost$2,283.That’swhatIcallmanagingyourrisk!

Beingsuchasmallpercentageofourtradingfloatmakesitmucheasiertogainback.Inthisexample,we’velostalittlemorethan10%.

It’simportanttounderstandthatthere’salittlemoretorecoveringafterdrawdownsthanmeetstheeye,asdemonstratedinfigure3.1andtable3.1.


Figure3.1:Recoveryafterdrawdowns–graph

Table3.1:Recoveryafterdrawdowns–table

Drawdowns Gaintorecovery

5% 5.3%gain10% 11.1%gain15% 17.6%gain20% 25%gain25% 33%gain30% 42.9%gain40% 66.7%gain50% 100%gain60% 150%gain75% 300%gain90% 900%gain

Calculatingyourpercentagerisk

Whenyou’restartingout,applyinggoodmoneymanagementishardwithaverysmallfloat–andthat’swhyinthepreviouschapterImentionedstartingwithatleast$10,000.Ifyouaretradingwithlessthan$10,000youmayneedtotakeonslightlymorerisk.Howmuchyouriskreallydependsonthesizeofyourfloatandyourtoleranceforrisk.

Gainrequiredtorecoupinpercentages

Lossinpercentages

1200%percentage

1000%percentage

800%percentage

600%percentage

400%percentage

200%percentage

0%percentage

0%percentage

‐100%percentage

‐80%percentage

‐60%percentage

‐40%percentage

‐20%percentage


Aroughguidemightbe:

Floatsize Percentagerisk$5,000–9,999 (4%)$10,000–99,999 (2%)$100,000–199,999 (1.5%)$200,000+ (1%)AsI’vesaid,yourgoalintradingshouldbesurvival.Ifyoucansurviveintrading,theprofitswillcome.Todothat,youneedtopositionyourselfsothatyoucanendurelongstringsoflosses.Inthisway,whenthemarketdoesturnaround,you’llbeinexactlytherightpositiontocapitaliseontheupturn.That’swhatsettingamaximumlossisallabout.

Mostpeoplegetscaredoffwhenthemarketgoesdown.Theyquit.Ironically,that’swhenthemarketusuallyturnsaroundand,bythetimethey’verealisedit’sturnedaround,that’swhenitusuallyfalls.Sowhat’stheaimofthegame?Tostayinthemarketthewholetime.Whenthemarketdropsyoureduceyourlossesandwhenitspringsupagainyou’reallcashedupandreadytotakeadvantage.

Sidenote:Onceyouhaveopenpositions,howthendoyouvalueyourtradingfloat?Let’ssayyougetasignaltoopenupanewposition.Youthenneedtocalculatethenewvalueofyourtradingfloatsoyoucandetermineyourmaximumrisk.Inshort,youshouldalwaysvalueyourpositionsbasedontheirinitialstoportrailingstop,whicheverisclosertotheprice.I’lltalkmoreaboutstopsinthefollowingchapters.

Calculatingyourtradingfloatforleveragedinstruments

It’simportantthatnovicetraderscalculatetheirtradingfloatforleveragedinstrumentsonwhattheyhave–nottheleveragedvalue.Usingleverageinstrumentsonlymagnifiestheresultsyou’realreadygettingandshouldonlybeusedbythosewhoknowtheirsystem’smetricsandhaveprovenittradesprofitably.Justbecauseyouput$1,000downintheforexmarketandgetcontrolof$100,000,don’tthenmakethemistakeofbasingyourtradingdecisionsonhaving$100,000.Onlyadvancedtraderswithaprovensystemshouldevervaluetheirtradingfloatbasedontheleveragedoutvalue.


You’re protective stop is like a red light. You can go through it, but doing so is not very wise!

RichardHarding

Chapter4:

InitialstopHowmanytimeshaveyouheldapositiontoolong?Everyonehasatsomepointintheirtradingcareer.OvertheyearsIhavelearnedthatit’smucheasiertotakeasmalllossthanabigoneandtheimportantthingtorememberisthateverybiglossstartedoutasasmallloss.Theartofplacinginitialstopsistocatchalosswhileitremainssmall.Itonlygetsharderasthelossgetsbiggerandyouregogetsmoreandmoresquashedintotheground.

Theinitialstopisapredefinedpointatwhichweexitaposition,shouldthetradenotgoinyourfavour.Whenweenteraposition,wedon’tknowatwhatpointinthetrendweare.Wemightbeenteringjustbeforethetrendchanges.Whoknows?Accordingly,weneedtosetanexitpoint.It’slikedrawingalineinthe

sandunderneaththepriceandsaying,‘Ifthepricefallsbelowthisline,thenthestockhasn’tdonewhatwethoughtitwasgoingtodo,thereforewe’llexittheposition.’

Figure4.1showsabasicrepresentationofthisconcept. Figure4.1:Settinganexitposition

Settinganinitialstop

AsImentionedintheintroduction,beingasuccessfultraderrequiresmakingdecisionsthatarecounterintuitiveandoneofournaturaltendenciesistoholdlosingpositionstoolong.That’swhyit’simportanttoplaceaninitialstop.

Time

Price

Exit

Entry


OneofthemostcommonquestionsIreceivewhentradersarefirstintroducedtotheconceptofaninitialstopis‘HowwideshouldIsetmystop?’Or,inotherwords,howmuchroomshouldIgivethepricetomove?Unfortunately,therereallyarenodefinitiveanswersbecauseitlargelydependsonwhattimeframeyou’retrading.Ifyou’reashortertermtrader,you’regoingtohaveaninitialstopthat’ssetclosertotheprice.Ifyou’realongertermtrader,you’llgivethepricealittlebitmoreroomtomovebysettingyourinitialstopwider.

Onceyou’veidentifiedwhattimeframeyou’relookingattrading,yourinitialstopmustignorethenormalfluctuationswithinthatparticulartimeframe.Thatistosay,youdon’twanttohavetocloseoutofapositionjustbecausethepricemovedaspartofitsnormaltradingvolatility.Figure4.2demonstrateswhatImean.

Figure4.2:Settinginitialstops

Asfigure4.2shows,aninitialstopthatissettootight(1)willbetriggeredtooearlyandthetraderwouldbekickedoutofthetradebeforethepricehadachancetogoup.Settingyourinitialstopatposition2,ontheotherhand,willmeananexitisnottriggeredprematurely.

Settingtightstopshasitsdrawbacks.First,byhavingtightstopsyou’lldecreasethereliabilityofyoursystembecauseyou’llgetstoppedoutmoreoften.Second,andprobablyalittlebitmoreimportantly,bysettingtightstopsyou’lldramaticallyincreaseyourtransactioncosts.Togiveyourselfafightingchance,especiallyifyou’restartingwithasmallerfloat,you’llwanttotradeasystemthatdoesn’tchewthroughbrokerage.Consequently,thisisoneofthemajorreasonsIsteermyclientsintotradingsystemsoveraslightlylongertimeframe.

Time

Price

Entry

Initialstop(1)

Initialstop(2)


Initialstopmethods

ThereareessentiallyfourwaysIsuggestclientscalculateaninitialstop.Youneedtoselecttheonethatseems‘right’foryou.Thesecretisnotinwhichmethodyouchoosebutratherthatyoujustchooseone.

1.Percentagemethod

Whatisit?

Apredefinedpercentageofthepricethatyousubtractfromyourentryprice.

Example

Figure4.3:Applyingthepercentagemethod

Benefits

It’seasytocalculateandisabettersolutionthannotapplyinganinitialstopatall.

Drawbacks

Thecalculationdoesn’tconsultpriceactionand/orthevolatilityofanindividualinstrument.Differenttradinginstrumentshavedifferentriskprofilesanddon’tmoveatthesamerate.Usingafixedpercentagemethodcanlimityou,causingyoutogetstoppedouttooearlyortoolate.


2.Averagetruerange(ATR)methodWhatisit?

TheATRisthe(moving)averageofthetruerangeforagivenperiod.Thetruerangeisthegreatestdifferencebetween:

• thecurrenthighandthecurrentlow• thecurrenthighandthepreviousclose• thecurrentlowandthepreviousclose.

Verysimply,ATRdeterminesasecurity’svolatilityoveragivenperiod.Thatis,thetendencyofasecuritytomoveineitherdirection.It’sagreatindicatorusedinmanymoneymanagementcalculations.Mostchartingpackagessupplyit.ThismethodsimplysubtractsapredefinedmultipleoftheATRfromyourentryprice.Forourexampleshenceforth,we’llcalculatetheATRover30periods(IrecommendcalculatingtheATRoveraminimumof14).

Example

Figure4.4:ApplyingtheATRmethod


Benefits

Itconsultsvolatility,givingmorevolatiletradesgreaterroomtomoveandlessvolatileonesatighterstop.

Drawbacks

Thecalculationdoesn’tconsultpriceaction;thiscanmeanwemightcalculatetheinitialstopbutitmightnotbeatasupportlevel.Thismethodworksbestforlongertermsystemswithwideinitialstopssuchas3–4ATRmultiples. 3.Technicalmethod

Whatisit?

Sometradersenjoyreadingchartsand/orlookingatindicators.Formanytradersit’samatteroflookingatpriceactionandsettingastopbasedonthepriceaction.Irecommendsettingtheinitialstopafewpointsbelowsupporttogiveitroomtobounceshoulditneedto.

Example

Figure4.5:Applyingthetechnicalmethod

Benefits

Ifyou’regoodwithchartanalysis,technicalstopscanworkverywell.Ifindtechnicalstopsarebestsuitedtoshort‐termtrading.


Drawbacks

Thecalculationcanbesubjectivebecauseitrequiresacertainlevelofintuition.Thismeansthere’sarealdangeroflettingyouremotionsgetintheway.Technicalstopsmustbeappliedinadisciplinedway.IfpossibleIrecommendstillhavingsomerulesinplaceforsettingthesestops.4.Lowestlowmethod

Whatisit?

Lookforthelowestlowoverapredefinedperiodwheretheperiodisdeterminedbythetimeframeyou’retrading.SimilartothetechnicalstopsIliketosetmystopacoupleofpointsbelowtheidentifiedlow.

Example

Ifyourpriceentrywas$24andyourlook‐backperiodwas21daysduringwhichthelowestlowwas$21.55,youmightsetyourinitialstoplevelat$21.53.

Benefits

Itconsultsbothpriceandvolatility.

Drawbacks

Thecalculationcancauseananomalyifthestockshiftssidewaysforanextendedperiodandvolatilitydriesup.Thestopcanleavelittleroomforastocktomove.

Additionaltips

Timestop:Youmightwanttoaddinsomesortoftimestopinthecasethatyourstockismovingsidewaysforanextendedperiodoftimeandyourmoneyissittingtheredormant.Forexample,yourrulemightbeifithasn’tmoved2percentwithinacertaintimeframeyou’llexittheposition.Afterallthat’swhatstopsareallabout–puttingalineinthesandthatsays,‘Thisstockhasn’tdonewhatIthoughtitwoulddosoI’llgetout.’Leveragedproducts:Whereyou’retradingderivativeproductyourinitialstopsshouldalwaysbecalculatedontheunderlyinginstrument.Forexample,avoidcalculatingstopsbasedonanoptionsvalue.Alwayslookatwhatthederivativehasbeenbasedonanddoyouranalysisonthat.Thisisageneralruleandmaynotapplytoallderivativessincetheircalculations/makeupcanvarywidely.Shorting:Allthemethodsoutlinedinthischapterapplyontheshortsite.Simplytaketheprincipalandturnitupsidedown.Whentoexit:Ifyou’retradingend‐of‐day(orlonger)systemsyoumayfurtherfinesseyoursystembytimingyourexits.Youcaneitherexitonanintra‐daybreakofyourstoporwaitforaclosebelow.


Throughmytesting(andasageneralrule)Ifindforlongertermsystemsit’sbesttowaittillpriceclosesbelowyourstopbeforeexiting.Shortertermsystemsshouldexitonanybreachofyourstop.Withthatsaid,appropriatetestingshouldalwaysbeconductedbeforereachinganyconclusions.

Thesecret:AlthoughIpreferthelowestlowmethod,therereallyisnorightorwrongstopmethod.Bysimplyhavingastopinplaceyou’reontherighttrack.Onceyouhaveastopyoumustthendeterminehowwidetosetit.That’sthetrickandunfortunatelythere’snodefinitiveanswer…otherthantotestandseewhatworksbest.Whenyoufirstbeginoutliningyourinitialstop,justkeepinmindwhatsuccessfultraderTomBaldwinsaid:Thebesttradershavenoego.Youhavetoswallowyourprideandgetoutofyourlosses.He’ssimplyreferringtohavingastoplosssetand,moreimportantly,havingthedisciplinetosticktoit.


If you have an approach that makes money, then money management can make the difference between success and failure ... I try to be conservative in my risk management. I want to make sure I'll be around to play tomorrow. Risk control is essential.

MonroeTrout

Chapter5:

CalculatingyourtradesizeWehavenowreachedthepointwhereweneedtodiscussthemostimportantaspectofmoneymanagement:positionsizing.Whenwetalkaboutpositionsizing,we’reaskingthequestion,‘Howmucharewegoingtoputintoatrade?’

ManytradersI’veencounteredbelievetheyaredoinganadequatejobofpositionsizingbysimplyhavingtheirinitialstopinplace.Thisiswherethenovicetradergoeswrong.Calculatingyourpositionsizeiscriticalanditpullstogetherboththeinitialstopandmaximumlossintoplay.BeforeIgetontotheformulaIrecommendforcalculatingyouridealpositionsize,rememberit’snotwhenyougetinorwhenyougetoutthatdetermineshowmuchyoumakeinatradebutratherhowmuchyouputin.

TheformulaAlthoughverysimple,thefollowingformulaisextremelypowerful.Sincewe’vealreadycalculatedourmaximumlossandourinitialstop,wecansimplytakethesevalues,plugthemintoaformulaandcalculatehowmanyunitswecanpurchasewithouteverexceedingourmaximumloss.

Theformulagoeslikethis:thenumberofunitsisequaltoourmaximumlossdividedbyourinitialstopsize.

You’realreadyfamiliarwithwhatourmaximumlossis.Theothertermyoumaynotbefamiliarwithisstopsize.Thisissimplythedifferencebetweenourentrypriceandourinitialstopvalue,calculatedasinfigure5.1.

MaximumlossStopsize

=no.ofunits


Figure5.1:Calculatingthestopsize

Let’snowlookathowthisformulaworksinpractice.Ifourtradingfloatwas$20,000,andwewererisking2%,ourmaximumlosswouldbe$400.Ifourentrypricewas$1andourinitialstopvaluewas$0.90,ourstopsizewouldbe$0.10.Now,tousetheformula,thenumberofunitswecanpurchaseisequaltoourmaximumlossdividedbyourstopsize.

4000.10

Wecalculatethatwecanpurchase4,000unitsandweknowifthistradereachesourinitialstop,andwehavetoexitthetrade,weknowwe’renotgoingtolosemorethan2%ofourfloat($400).Thisformulaissimple,butveryeffective.Pleasenote:Forthesakeofexcellentmoneymanagementyoushouldalwaysrounddown.Forexample,sayyoucalculatethatyoucanbuy766.73units.Becauseyoucanonlybuywholeunits,besuretorounddownandbuy766units.Eventhoughit’sonlyasmallamount,youaretakingonmoreriskbyroundingup.Theonlyothercostyoumaywishtotakeintoconsiderationisbrokerage.Forexample,ifbrokeragewas$40forareturntrip($20inand$20out),we’dsubtract$40fromourmaximumloss.So,insteadofenteringourmaximumlossas$400intotheformula,we’dnowenter$360.Oncethisiscomputedout,wecandeterminehowmanyshareswe’dbuy,andweknowthatwe’reincludingbrokerageaspartofourmaximumloss.

=4,000

Entry

Stopsize

Time

Price

Initialstop


Ifwecontinuewiththeaboveexample,itwouldlooklikethis:3600.10AdditionaltipsMaximumpositionsize:AsI’vesaid,howmanyshareswecanpurchaseisdeterminedbyourmaximumlossandalsothesizeofourstop.Accordinglythereareonlytwowaystoincreaseourpositionssizes:(1)increasingourmaximumloss;and/or(2)shrinkingourstopsize–inotherwords,atighterinitialstop.So,toavoidasituationyouweopenexcessivelylargepositionsthatmightputyourtradingfloatatrisk,youmayalsointroduceanextrarulethatlimitsthedollarvalueofapositiontobenomorethanasetpercentageofyourentiretradingfloat.Thisprotectsyoufromtradinghalts,bustsorunexpectedandsignificantfalls.Forexample,youmightsayyou’llneveropenapositionthathasadollarvalueofmorethan25%ofyourentiretradingfloat.Thisrulewouldonlyevergetexecutedif,afterusingthepositionsizingformula,youfindthedollarvalueofthatpositionwouldbeanexcessivelylargepositionandgreaterthan25%ofyourtradingfloat.Ifthiswasthecase,youwouldsimplyscalebackthepositiontobe25%oryoucouldwidenyourstop.

Themaximumpositionsizepercentagevalueyoudecidetochoosewilldependonthetypeofsystem,thesizeofyourfloatandalsoyourpersonaltoleranceforrisk.Asaguidethough,smallertradingfloats($20,000)mightuse25%;whereas,largertradingfloats($200,000)mightuseaslittleas10%oreven5%.Leveragedproducts:Itcannotbeoverstatedthatnewtradersshouldonlyopenpositionswheretheycanowntheentirepositionoutright.Theyshouldtradethefloatasitwasnotleveraged.Onlyadvancedtradersshouldvaluepositionsbasedontheirleveragedvalue.

=3,600


You’ve got to know when to hold ‘em; know when to fold’em; know when to walk away; and know when to run.

KennyRogers

Chapter6:

Trailingstops Howmanytimeshaveyousoldapositiontooearly?IknowIhave.Andit’sfrustrating!Overcomingthistendencytosellbeforeastockhasreacheditsfullpotentialis,again,aboutcounterintuitiveactionscreatingsuccess.Generally,whatinexperiencedtradersdois,oncetheyseealittlebitofaprofit,theyselltocrystallisethatprofitstraightaway.Psychologicallyspeakingtheydon’tliketoloseandtheyfalselybelievethatthoseprofitsaretheirprofits–theydon’twanttogivethembacktothemarket.In this way they are looking to pick the top. A top is a very difficult exit to identify. It requires great skill in technical analysis and even then there is no guarantee that you will be right. Worse still, you will be kicking yourself if the trend were to continue after you had just exited!Thisisamisguidedtactic.Youneedtomasterthecounterintuitiveapproach.The best way, therefore, of exiting a position is to wait until the trend changes and exit at a point slightly lower than the top. This does mean that you will be sacrificing some of your profit but, in the long run, your trades will be much more profitable. You will be letting your profits run until you’re signalled to exit.

Sohowdoyouexit?Therearetwotypesofexitsthatcanbeappliedintrading:initialstops(discussedinchapter5)andtrailingstops.Trailingstopsinvolvemovingyourstopclosertopriceaspriceclimbs.Piggybacking,ifyoulike.

Asmentioned,yougenerallywanttoridethetrendaslongasyoucan.Theproblemisthatwhenthetradestartstolosesteam,itwillinevitablybegintodeclineinprice.Thismeansthatthebesttimetoexitisnotactuallyatthe‘top’butwhenthesharepricehasjustbeguntofall.You’llneverpickthetopsomakesureyouexitjustasitrollsover.

Figure6.1showsthisinalittlemoredetail.


Figure6.1:Theidealentryandexitpoint

Asyoucanseeinfigure6.1,thereisasmallgapbetweenthepeakandtheexitpoint.Thismeansyouwillneverpickthetopandyouwillhavetogiveupasmallproportionoftheprofitwhenthetrendstartstoreverse.

Note:Theonlyexceptionmaybesomeveryshort‐termderivativestrategieswhereyoumayneedprofittargets(buttheyaretheexceptionratherthantherule).

Theroleoftrailingstops

Asimpleexamplecanillustratetheimportanceofatrailingstop.Saywereceivedabuysignal,purchasedXYZstockandsetourinitialstop.Thestockthenrisesandcontinuestoriseafewhundredpercent.Withoutatrailingstopandwithonlyaninitialstopsetwewouldnotgetoutofthattradeuntilitrevertsallthewaybackdowntobelowwhereweboughtit(atourinitialstoppoint).Theresultisweenduplosingmoneyeventhoughtherewaspotentialforsomefantasticgains.Thissituationisalltoofamiliarinboom/busttimesinhistorysuchasthetechcrashof2000.Sohowdowelockinthatprofitwhilewehavethechance?Enter:thetrailingstop.

Trailingstopsaresimilartoinitialstops,theonlyrealdifferencebeingthattrailingstopsareadjustedperiodically.Forexample,afterthefirstdayoftradingifthepricemovesinourfavourthenthetrailingstopismovedclosertoprice.Itliterally‘trails’behindprice.

Thekeytotrailingstopsisthatyouneedtocontinuallymakeadjustmentstomakesurethatthestoplocksinprofit.Typicallythewayinwhichatrailingstop

Entry

Exit

Peak

Time

Price

Profit


lossiscalculatedisverysimilartothewayinwhichwecalculatedourinitialstop.Asmentioned,theonlydifferencebeingthatratherthancalculatingourtrailingstopfromtheentryprice,wecalculateitfromthehighestpricesinceentry(for‘long’trades).Inotherwords,thetrailingstopmovesclosertopriceonlyaspricemakesanewhigh.Ifpricedecreasesthetrailingstopremainsfixed.Forexample,sayweboughtXYZstockat$10andhaveplacedourinitialstopat$9.90.Wehavedecidedtohaveatrailingstopof$0.10.Figure6.2displaysthisgraphically.

Figure6.2:Increasingtrailingstopsgraph

Lookingatfigure6.2,youcanseethatbetweendays5and7thepositionstartedmakinglowerhighsbutthetrailingstopremainedfixed.Asimilarthinghappenedbetweendays11and15exceptthatonday15,thelowactuallywentthroughthetrailingstop.Accordinglyweexitthepositionat$10.20.Thismeansthatwehavemadea$0.20profitperunitusingatrailingstoploss.


Methodsofcalculation

Themethodsusedforcalculatingatrailingstoparethesameasforinitialstops(asdefinedinchapter5).Herearesomequickexamples.

Percentagemethod

Highesthighsinceentry: $3.31

Percentageapplied: 10%(10%x3.31=$0.33)

Trailingstop: $2.98($3.31‐$0.33=$2.98)

Figure6.3:Calculatingatrailingstopusingthepercentagemethod

ATRmethod


ATR(30): 0.17

ATRmultiple: 3($0.17x3=$0.51)

Trailingstop: $4.38($4.89‐$0.51=$4.38)Extrapoint:Ifthepositionmovessideways,andvolatilitydriesupcausingthevalueoftheATRtoshrink,thisstopwillgettighterasaresult.


TechnicalmethodHighesthighsinceentry: $7.52

Support: $7.00

Trailingstop: $6.98

Caution:technicalstopsareevenmoresubjectiveonceatradeisopen.Youremotionreallytakesoveronceyouhavecommittedrealmoneytoatrade.

Lowestlowmethod


Lookbackperiod: 21days

Lowestlowinpast21days:$26.42

Stoplevel: $26.39

AdvancedtipsSettingwidetrailingstops:Aspartofyourtestingyoumightlookatsettingtighterinitialstopsandwidertrailingstops–Ihavedonethiswithgreatsuccess.Forexample,youmightseta2ATRinitialstopandthenyourtrailingstopmightbe3ATR.Whatyou’rethendoing,ineffect,islimitingyourinitialrisk.Onceyourtradeisinprofit,itgivespricemoreroomtomove.Inthiswayyoubecomeriskseekingwheninprofitposition.Unsuccessfultradersdotheopposite:beinggreedywhentheyshouldbefearfulandfearfulwhentheyshouldbegreedy.Withthatsaid,thereisnotechniquethatisidealinallsituationsandyoumayfindthatonetechniquemaybegoodinonestockandnotanother.Itisthereforeimportantthatyoubacktestyourtradingsystem.Aboveall,keepitsimpleandmanageable.

Tradingfloatsize:AsImentionedbrieflyinchapter2whentalkingaboutyourtradingfloatsize,youshouldalwaysvalueyourtradingpositionsattheirstopvalue.Thatistosay,thenumberofunitsmultipliedbythestoppriceequalsthepositionvalue.Youcanthenusethesefigures,addedtoanycashinreserves,whencalculatingyourtradingfloatsizeandsubsequentlyyourmaximumrisk/newpositionsizing.Whenyoudigalittledeeper,andconsideryouwillalwaysgiveprofitsbacktothemarket,thisbecomesself‐evident.Systemanalysis:Avoidcalculatingasystem’srisk–rewardratiobasedonyourprojectedprofittargets.Theproblemwithdoingthiskindofanalysisbeforeyouenterapositionisthatyouknowtheinitialriskbutyoudon’tknowyourreward.Thisratiocanonlybecorrectlycalculatedwhenbacktestingasystem.


Thisisagoodapointinthebooktotakeabreatherandrevieweverythingwe’velearned.Thenextchapterfeaturesafullyworkedexamplethatincorporatesallaspectsofwhatwe’vecoveredupuntilthispoint.


Chapter7:

FullyworkedexampleIn this example, assume that you have identified a trading candidate that youbelievehasgreatpotential.Theinitialrules

Float $20,000Maximumrisk 2%Maximumloss $400Brokerage $40

Maxlossex.brokerage $360Tradesize Maximumloss($)/stopsize($)

Positionsizelimit 30%($6,000)

Initialstop 3ATR(30)Trailingstop 4ATR(30)Timestop N/A


Day1:EntryTriggeredFigure7.1:Day1:Entrytriggeredandexitspredefined

Day1events:Youenterthestockanddefineyourstoplosses.Entryprice $10.50ATR(30) $0.171Initialstop 3xATR=$9.99 ($10.50‐$0.51=$9.99) Trailingstop 4xATR=$9.82 ($10.50‐$0.68=$9.82) Numberofshares 360/0.51=705.88(inc.brokerage)Positionsize 705x10.50=$7,402Thepositionsizingcalculationresultexceedsourmaximumlimittherefore,itwouldbeadvisedtoscalethepositiondowntobenolargerthan30%ofthefloat(i.e.$6000).Thecalculationforthiswouldbe:$6000‐$40brokerage/10.50=567units(roundeddown).(567*10.50entryprice)‐(567*9.99initialstop)+40brokerage)=$349.15)Newmaximumloss $349.15Entrycosts 567x10.50+40=$5,993.50

1FortheeaseoftheexampletheATR(30)willremainstatic.


Day2:AlterationoftrailingstoplossFigure7.2:Day2:Trailingstopmovesup

Day2events:Thestockmovesslightlyhigher.Theinitialstopremainsfixedanddoesnotmove.Thetrailingstopmovesupslightly.However,becausetheinitialstopisstillhigher,thetrailingstopremainsinactive.


Day3:MakingtheinitialstopobsoleteFigure7.3:Day3:Trailingstopovertakesinitialstop,makingtheinitialstopobsolete

Day3events:Thestockmoveshigheragain.Theinitialstopremainsfixedanddoesnotmove.Thetrailingstopmovesupandovertakestheinitialstop,makingtheinitialstopobsoleteandthetrailingstopbecomesournewexitprice.Althoughthestockhasmoved25centsinourfavourwehaven’tmadeaprofituntilourtrailingstopishigherthanourentryprice.


Day5:Leavingstoplossunaltered(1)Figure7.4:Day5:Highesthighachievedyesterday(day4);trailingstopdoesnotmove

Day5events:Twodayslateranewhighisachieved.Todaythestockretracedfromthatnewhigh.Ourtrailingstopispeggedtothehighesthighsinceentryandassuchremainsstatic.


Day22:Leavingstoplossunaltered(2)Figure7.5:Day22:Highesthighachieved(day4)trailingstopdoesnotmove

Day22events:Seventeendayslaterthestockfailstoachieveanewhigh.Note:DuringperiodswhereastockmovessidewaystheonlywayourtrailingstopcouldhavemovedupwasifthevolatilitydriesupandtheATR(30)valuedeclined.


Day23:IncreasingtrailingstoplossFigure7.6:Day23:Newhighesthighachieved(day24);trailingstopmovesup

Day23events:Twodayslaterourstockbeginstomoveinourfavour.Itmakesanewhighandonceagainourtrailingstopisonthemove.Onthisdayourtrailingstopisgreaterthanourentrypriceandwearenowinaprofitabletrade.


Day63:GettingstoppedoutFigure7.7:Day67:Highesthighachieved(day62)

Day67events:44dayslaterwereceiveanexitsignalwhenthecurrentperiod’slowbreaksourtrailingstoploss.Weexitwithaprofit.

FinaltradesummaryEntry $10.50Exit $11.77Profit/Loss 11.03%Risk–rewardratio21:1.8Profit/loss 565x11.77–30–5,962.50=$657.55Insummary,thistradehasproducedaprofitof$657.55orareturnofabout11%onourinitialinvestment.

2Aratiousedbymanyinvestorstocomparethereturnsofaninvestmenttotheamountofriskundertakentocapturethesereturns.Thisratioiscalculatedmathematicallybydividingtheamountofprofit(i.e.thereward)bytheamountheorshewouldloseifpricehittheinitialstoploss(i.e.therisk).


I’m more concerned about controlling the downside. Learn to take the losses. The most important thing about making money is not to let your losses get out of hand.

MartySchwartz

Chapter8:Theworsttradingstrategy

Asyou’venodoubtcometorealise,thereareamillionandonestrategiesthatcanbeappliedtoallaspectsoftrading.I’mgoingtosharewithyouwhatIconsidertobeoneoftheworstifyouconsideryourselfasatrader.

YoumaybewonderingwhyIwouldwanttospendtimeillustratingtheworsttradingstrategyaround.It’ssimple.Byshowingyouhowitworks(or,inthiscase,doesn’twork),Ihopetoshowyouclearlywhatnottodowhileencouragingyoutodotheexactopposite.Averagingdown:theworsttradingstrategyofalltimeUnfortunately,forthebeginner,averagingdownseemsquitelogicalbutitisfundamentallyflawed.Manypeoplehavebecomestuckinitsclawsandhavelostsubstantialamountsofmoneybecauseofitsapparentlogic.Donotbeoneofthem!Averagingdownistheprocessofbuyingmoreandmoreunitsofafallingstockinadesperateattempttorecoupyourlossesandreduceyoureffectivebuyprice.Whenyoulookatitclosely,it’sreallyjustthrowinggoodmoneyafterbad.

Thementalstatebehindthistypeofstrategyisdenial.Peoplebelievetheycanreducetheirinitialentrypricebycontinuingtobuymoreasthestock’spricefallsaway.It’sthemodusoperandiofdistressedtraders,tradersinapanic.Asastrategyitishardlyevereffective.Tomakemattersworst,you’llmagnifyyourlossesifthestockkeepsdropping.

Pleaseunderstand,justbecauseit’scheapnowdoesnotmeanit’snotgoingtogetany

cheaper.Here’showthisstrategyworksinaction.Let’ssayyoubought1,000sharesat$40.Stepone,don’thaveaninitialstopinplace.Steptwo,watchthepricefallto$30anddonothing.Herecomesthestupidityofthisstrategy–stepthree,buyanother1,000unitsat$30tolowertheaveragecostperunitalreadypurchased.Youraveragecostperunitwouldnowbe$35.Itgetsworse.Pricemayfallevenfurtherandthenovicetraderwillagainbuymoreunitstoreducetheeffectiveaveragecostperunit.Theeffectissuchthathebuysmoreandmoreintoastockthat’slosinghismoney.Now,imaginethisstrategybeingappliedtoaportfolioofstocks.Whatendsuphappeningisthatallyourtradingcapitalisallocatedtotheworseperforming


stocksintheportfolio.Theresultis,atbest,adisastrousunderperformanceversusthemarket.

Ifatraderaveragesdownandisusingmargin,thenyoucanonlyimaginethiswouldmagnifythoselossesevenfurther.Theeffectscanbedevastating.So,hearmenow:neveraveragedown.

Averagingup:thesmarterwaytogoLet’sturnthisstrategyonitsheadandseehowwecanusethisideainapositive,moreprofitableway.Averagingup(or‘pyramiding’)worksbysimplydoingtheoppositeofaveragingdown.Thatistosay,weaddtoalreadyprofitablepositions.There’snohardandfastrulesherebutthebasicpremiseisthatyou’readdingtoanalreadyperformingposition.

Toimplementthisstrategythetwodecisionsyouneedtomakeare:

• atwhatpointdoyouaddtoyourposition,suchas:o whenyougetanewentrysignalo whenyouhavemadexpercentprofito atechnicalpointsuchasbreakingaprevioushigh

• howmuchtoaddo somepeopledoubleup,othersaddapercentageoftheiroriginal

positionsuchas25–50%

Acoupleofpointstonote.Thisstrategylendsitselfbesttoatrendfollowing/longertermsystem.Also,treateachpositionasthoughitwaswereanindependent.Youwillprobablyendupusingthesamestopsbutwhenyoucalculateyourpercentagerisk,applyitasthoughit’sanewtrade.


Chapter9:

TakingprofitsandlearningfrommistakesNowthatyouknowhowtoprotectyourmoneywithgoodmoneymanagement,here’sasimplebutimportantlesson.

Thepointatwhichyoutakeyourprofitsoutofthemarket(outofyourtradingfloat)dependsonyourobjectives.Ifyou’retradingforincomeyou’reobviouslygoingtoneedtopullmoneyonamoreregularbasis.Ifyouraimiscapitalgrowth,youshouldleaveyourcapitalforathreetofive‐yearterm,lettingthemagicofcompoundgrowthtakeeffect.

Compounding:TheeighthwonderoftheworldIknowyou’veprobablyhearditbeforebut…compoundingisaveryusefulandpowerfulmethodofgrowingyourcapitalbyreinvestingyourprofitsintoyourinvestments.Thepowerofthisprincipleisdemonstratedinthefollowingexample.Let’sassumethatwehave$10,000andthatourtradingsystemreturnsapproximately20%peryear.Ifwetakealltheprofitsweearnoutofthemarket,withoutreinvesting,theannualreturnona$10,000accountisapproximately$2,000.In10years’time,wewillhaveprofitedtothetuneof$20,000.

Let’snowaddinthepracticeofcompoundingourwinnings.Inotherwords,wewillnotwithdrawthe20%profitbutwillreinvestthemoneyintoouraccount,allowingthemoneytocompound.Theexamplebelowshowshowmuchmorewecanexpecttomakebyusingthissimpleandeffectivemethod.

Table9.1:Thepowerofcompounding

Year Totalaccountvalueat20%growthandcompoundingthe

winnings0 10,0001 12,0002 14,4003 17,2804 20,7365 24,8836 29,8597 35,8318 42,9989 51,59710 61,917


To be a money master, you must first be a self-master.

JPMorgan

Table9.1showsthattheinitialseedcapitalhasgrowntoalmost$62,000in10years,producingareturnofapproximately$52,000!Thisisapproximatelytwoandahalftimestheamountyoucanexpectfromnotcompoundingyourwinnings.Justimaginewhattheresultswillbeonceyouhavemasteredtradingandproduceareturnhigherthan20%perannum.LearningfrommistakesMistakeswillinevitablyhappeninyourcareerasatrader.Thesameappliestoanyonetakingonsomethingnew.Forexample,whenmostpeoplestartanewjob,theyneedlotsofhand‐holdinguntiltheyarecomfortablewiththeirnewrole.Tradingisnodifferent.Unfortunately,mosttradersdon’thavethat‘somebody’tolookovertheirshoulder;thereisnoonetoguideandcorrectthemwhentheyhavemadeamistake.Thetrader,forthemostpart,needstolookatherowntradingpatternsandbeself‐correcting.Thiscanbeatallorder,especiallywhenyoudon’trealiseyouhavedoneanythingwrong!

TwotypesofmistakesIbelievetherearetwotypesofmistakes:mistakesyouhavemadeandmistakesmadebysomeoneelse.Thefactis,it’shumannaturetolinkmorepaintothemistakesthatyouhavemadeyourselfasopposedtothemistakesofothers.Asaresultit’seasiertolearnfromyourownpainfulmistakesthanthemistakesofothers.

Mindfulofthis,Iencouragetraderstothinkofthefirstonetotwoyearsoftheirtradingcareerasanopportunitytolearnfromyourownmistakes.Themoremistakesyoumakeinitially,themoreyouwilllearn–butonlyifyouconsiderthemaslearningexperiencesasopposedtoeventsyoubeatyourselfupover!

ThebiggestmistakeIevermadeThebiggestmistakeIevermadeinmytradingcareerwastryingtotradewithoutaplan.Weallknowawell‐designedtradingplanistheessentialelementofanygoodtrader.Theplanistheretoinstructyouwhattodo,whentodoitandhowmuchtodoitwith.

Inmyopinion,unlessyourplaniswrittendown,youdon’thaveaplan.Aplanwillmakeyoutradeconsistentlyandhelpyoutominimiseyourlosseswhilemagnifyingyourgains.Throughoutthisbookyouhavelearnedaboutthemostimportantaspectoftradingplan:moneymanagement.Followingwhatyou’velearnedyounowneedtodocumentitandincludeitinyourownplan,suchasdemonstratedintable9.2.


Table9.2:Samplemoneymanagementrules

Longterm Shortterm

Definefloat $20,000 $100,000

Initialstopmethod 2ATR 7‐daylow(2pointsbelow)

Maximumloss 2% 1.5%

Maximumpositionsize 30% 10%

Trailingstopmethod 3ATR 7‐daylow(2pointsbelow)

Willyouaverageup?Ifso,how?

Yes.Add50%oforiginalpositionifentrytriggeredagain

No

Asmentioned,moneymanagementisthemostimportantaspectofyourtradingplanbutthatdoesn’tdiscountthefactthatthereareotherareas(suchasyourentryrules)youmustconsider.Formoreinformationondesigningotherpartsofthesystempleasevisitwww.freetradingsystems.org


Tradingwithoutacoach

Iwantedtofinishthisbookwithanoteabouttradingcoaches.IdosobecauseIthinkit’simportant.

Askyourselfthis:Ifyouwanttolearnanewlanguage,howwouldyougetstarted?Youwouldmostlikelygotoaclassandlearnfromsomebodymoreexperienced.Inasimilarmanner,ifyouwantedtoimproveyourtradingskills,youshouldfindacoach.Tradingisgenerallyalonelyvocation.What’smore,duetothesolitarynature,manytradersfinditdifficulttoimprovetheirskills.Coachesarenecessarytohelpyouidentifywhereyouaregoingwrongandsteeryouintherightdirection.Thefactis,alltopperformershavecoaches.TakeTigerWoods,forexample.He’sconsideredthegreatestgolferofalltimeandyethestillhasacoach.Whydoyouthinkthatis?Coachesarerequiredforthosewhowishtoperformattheirpeak.Ibelievefivehundreddollarsspentonimprovingyourselfthroughatradingcoachismuchbetterthanlosing$10,000inthemarkets.

Furthertradingsupportcanbefoundbyvisitingwww.onlinetradingmastermind.com

Documents

Trading Secrets Revealed 2.0©| David · PDF fileof the golden rules of trading. We all know that. But ... it’s also going to tell them the exact point at the top of the trend when